portfolios using a broad range of asset classes and shows how finance professionals increasingly use Liability Driven Investment frameworks to do this. Liability Driven investment for convenience is commonly known as LDI. LDI is sometimes also described as Asset-Liability Management (ALM) or in the States Dedicated Portfolios. We live in a world where the bulk of our pension money, in the UK at least, is invested with an LDI strategy at its core. In the rest of the developed world the techniques and frameworks are gaining increasing acceptance and market share. It is likely that this trend will continue. However despite its importance the strategy is unknown to even most financial professionals. With most of the advanced portfolio management textbooks focusing on the peculiarities of Fixed Income Wiley felt a broader guide was overdue. To describe how LDI works we look at the major asset classes, the basics of fund selection and management, and how to use these building blocks to create a diversified portfolio. We also look at the regulatory and ethical issues involved in creating multi-asset class portfolios and how these will impact the industry in the future.
The book can be used as a guide for pension fund trustees as they negotiate an increasingly complex regulatory landscape, but the text is very much aimed at the lay person with the aim of building up an investment strategy from first principles. It is first and foremost a book about investment theory, addressing the risk management frameworks currently used in capital markets across the globe to create modern investment portfolios. Later, we move on from purely investment matters to explain the some of regulatory systems in which financial professionals work in, and the regulatory obligations that are placed on professionals and amateurs alike when advising on investments. We also go on to look at the impact technology has had on how and when we invest, and how technology is likely to create further changes in the near future.
I will attempt to explain the numerous theories that underpin modern finance: in particular, Modern Portfolio Theory and the theoretical work of Harry Markowitz that underpins how the bulk of our pensions are invested. We then expand from MPT to look at risk frameworks that take into account both sides of an investor's balance sheet. Incredibly elegant and taught on every undergraduate finance course, MPT is the most influential financial theory in use today, and it will remain so tomorrow. It starts with the assumption that risk-averse investors will construct portfolios to maximise expected returns based on a certain level of market risk. However, Modern Portfolio Theory stems from original work in 1952 and some of the assumptions are not ideal for the needs of a pensioner in the twenty-first century. By neglecting one side of an individual or pension plan's balance sheet, MPT could be said to be looking at half the problem. (Although this is perhaps mean, as the assumptions are clearly laid out and there are frameworks explicitly developed from MPT that do include Liabilities.)
The field of Liability Driven Investment is particularly relevant to anyone with a pension, which in the UK at least is effectively all of us. We have seen talk in the press of ‘Peak LDI’ in the last few years as more and more pension schemes utilise cash flow driven frameworks. But growth has continued, indeed at the time of writing hedging of institutional portfolios against changes in UK interest rates and against inflation has increased to another record high. Growth will also continue in markets with limited take up, it is also likely that Digital or FinTech solutions will create a trickle down affect to the High Street.
The core idea behind LDI frameworks is that rational investors would not look to maximise real assets, subject to risk constraints as in traditional frameworks – usually defined as volatility with total portfolio value. Rather an investor would seek to maximise the profit – subject to constraints on the variability of the surplus, and subject to meeting cashflows that are defined as needs rather than wants. This approach can make a huge difference to portfolio construction and user outcomes. It also shifts the focus of investors from equity prices to long-term treasury or government yields because the volatility of the present value of the liabilities is related to the volatility of the funding status.
Across the world falling bond yields have created pension fund deficits since the global financial crisis. This is despite rising stock prices and limited portfolio impact from credit loss. Rising asset prices have not been enough to counteract the increase in liabilities for a large number of pension schemes, as funding deficits have increased despite an equity bull market. This is due to under-hedging of the liabilities. The implication is that a focus on asset-price optimization may not be enough in a world of long-dated liabilities and that LDI might be the solution.
This book has three parts to it, broadly matching the subtitles Pensions, Regulations and Robo-advice, although we may also have described the focus as: i) Investment and Risk; ii) Regulation and ethical considerations; iii) The Impact of Technology.
The first part, which stretches through the first half of the text, consists of an introduction to the asset classes available to the modern investor. Alongside an introduction to investment funds, why they are important and how to choose them. There is also a brief explanation of both discounted cash flows and investment management frameworks which should be familiar territory for anyone who has taken a finance or economics class in the past.
The second part looks at regulation, the changing regulatory landscape, and the obligations upon stakeholders in the investment world. Regulation is more important to finance professionals than it has ever been, and we expect to see continued growth in the number of, and complexity of, regulations as markets become more and more complex. We also look at ESG (Environmental, Social and Governance) criteria and investigate how finance is more than a simple question of risk and return. With ESG criteria incorporated into regulations and the investment process, we expect social considerations to become an increasingly important part of the investment process.
The third part looks at the digital landscape and the impact of technology. The rise of WealthTech and the likelihood of digital disruption (so far it is early days), including the distribution of advice and financial products such as LDI, is likely to change dramatically over the next few years as processes become less human-led and more commoditised. This will bring mass distribution of investment solutions and lower costs to us as consumers of financial products – but it also creates risks.
We hope you find this book useful.
Daniel Tammas-Hastings
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